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When it comes to estate planning and life insurance, you’ll often hear financial advisors and insurance professionals recommending that you set up a separate trust to own your life insurance policies. On the surface, it sounds like a smart move – after all, who doesn’t want to minimize taxes and protect their assets? But as someone who’s spent years helping people navigate the complex world of finance and insurance, I’m here to tell you that life insurance trusts aren’t always the golden ticket they’re made out to be.
Now, don’t get me wrong. I’m not saying life insurance trusts are inherently bad or that they never make sense. But what I am saying is that you need to be very careful and fully understand what you’re getting into before you jump on the trust bandwagon. There are some hidden dangers that can seriously impact the effectiveness of these trusts, and I’ve seen too many people get burned by not knowing the full story.
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So let’s dive in and take a closer look at life insurance trusts – the good, the bad, and the ugly. By the end of this article, you’ll have a much clearer picture of whether a life insurance trust is really the right move for your situation.
Before we get into the potential pitfalls, let’s make sure we’re all on the same page about what a life insurance trust actually is. In simple terms, it’s a special type of trust that’s set up to own and control your life insurance policies. Instead of you personally owning the policy, the trust becomes the owner and beneficiary.
The main reason people use these trusts is to try and keep the life insurance proceeds out of their taxable estate. You see, while life insurance payouts are generally income tax-free to beneficiaries, they can still be subject to estate taxes if you own the policy yourself. By having a trust own the policy instead, the idea is that you can shield those proceeds from estate taxes.
This can be especially appealing if you’re worried about your estate exceeding the federal estate tax exemption (which is $13.61 million per person in 2024) or if you live in a state with its own estate tax that kicks in at a lower threshold.
Sounds pretty good so far, right? Well, hold onto your hats, because we’re about to get into why it’s not always as rosy as it seems.
Here’s a big one that a lot of people don’t realize until it’s too late: If you transfer an existing life insurance policy into a trust, you have to survive for at least three years after the transfer for it to be effective for estate tax purposes. If you die within those three years, the full value of the policy gets sucked right back into your taxable estate.
Now, you might be thinking, “No problem, I’ll just have the trust buy a new policy instead.” And that can work – but it comes with its own set of challenges, which we’ll get to in a minute.
Every time you contribute money to the trust to pay premiums, it’s considered a gift for tax purposes. You can use your annual gift tax exclusion ($18,000 per person in 2024) to cover some or all of this, but it’s not as simple as just writing a check.
To qualify for the annual exclusion, the trust beneficiaries need to have what’s called “present interest” in the gift. This usually means setting up complicated “Crummey powers” that give beneficiaries a limited time to withdraw the gifted amount. It’s a hassle, and if not done correctly, you could end up using part of your lifetime gift tax exemption or even owing gift taxes.
Once you put a policy in an irrevocable trust, you’re largely giving up control. Want to change beneficiaries or borrow against the policy’s cash value? Too bad – those decisions are now in the hands of the trustee. This loss of flexibility can be a real problem if your circumstances or wishes change down the road.
Setting up and maintaining a life insurance trust isn’t a DIY project. You’ll need to work with an experienced estate planning attorney to draft the trust document, and you may need ongoing legal and tax advice to make sure you’re managing it correctly. All of this adds up to higher costs and more paperwork compared to simply owning a policy outright.
With all the moving parts involved in a life insurance trust, there’s a lot of room for error. Forget to send Crummey notices to beneficiaries? Fail to pay premiums on time? Have a trustee who doesn’t understand their duties? Any of these mistakes could potentially invalidate the trust or cause other unintended consequences.
If you’re using a permanent life insurance policy like whole life (which I often recommend for other reasons), having it owned by a trust can limit your ability to fully leverage the policy’s cash value. You might miss out on opportunities to use that cash value for investments or other financial strategies.
Estate tax laws have a habit of changing. What if the estate tax exemption goes up even higher or the estate tax is eliminated altogether? You could find yourself stuck with a complex trust structure that’s no longer necessary.
Now, after all that doom and gloom, you might be wondering if there’s ever a good reason to use a life insurance trust. And the answer is: it depends on your specific situation. There are certainly cases where the benefits can outweigh the drawbacks.
For example, if you have a very large estate that’s well over the federal exemption amount, and you’re buying a new life insurance policy specifically for estate liquidity purposes, a trust might make sense. Or if you’re in a state with a low estate tax threshold and you want to protect a significant life insurance payout from state-level taxes, a trust could be worth considering.
But here’s the key: it needs to be part of a comprehensive estate plan that takes into account all of your assets, goals, and potential tax liabilities. It’s not a one-size-fits-all solution, and it’s definitely not something you should rush into just because someone told you it’s a good idea.
For many folks, I believe there’s a simpler and more effective way to use life insurance as part of your financial strategy: a well-designed participating whole life insurance policy.
Here’s why I often recommend this approach:
Now, I know whole life insurance has gotten a bad rap in some circles. People say it’s expensive or that you’re better off buying term and investing the difference. But the truth is, not every whole life policy is created equal. When properly designed and used as part of a comprehensive financial strategy, it can be an incredibly powerful tool.
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The key is working with someone who understands how to structure these policies for maximum benefit and who can show you how to use them effectively. That’s where we come in at McFie Insurance. We specialize in designing high-cash value whole life policies that give you the protection, growth, and flexibility you need.
Life insurance trusts can serve a purpose in certain high-net-worth estate planning situations. But for most people, the complexities, costs, and potential pitfalls outweigh the benefits. Before you go down that road, make sure you fully understand what you’re getting into and consider whether there might be simpler, more effective alternatives.
If you’re trying to figure out the best way to use life insurance as part of your overall financial strategy, I encourage you to look beyond the standard advice and explore all your options. A well-designed whole life policy might be just what you need to protect your family, grow your wealth, and create the financial future you’re dreaming of.
At McFie Insurance, we’re here to help you navigate these decisions and find the solution that’s right for you. We don’t believe in one-size-fits-all approaches or pushing products that don’t make sense for your situation. Instead, we take the time to understand your unique needs and goals, and then we work with you to create a customized strategy.
So if you’re ready to take control of your financial future and want to learn more about how life insurance can play a role, why not schedule a strategy session with us? We’ll answer your questions, walk you through your options, and help you make an informed decision about what’s best for you and your family.
Remember, when it comes to your finances, knowledge is power. Don’t let anyone push you into a complex trust arrangement without fully understanding the implications. Take the time to educate yourself, ask questions, and explore alternatives. Your future self will thank you for it.
Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. Tom McFie is the founder of McFie Insurance which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, A Biblical Guide to Personal Finance, can be purchased here. 
Dr. Tomas P. McFie
